Does Another Lehman Have Your Money?

One letter can make a huge difference in your portfolio — especially the letters “F” and “N.”

For instance, consider the investments called ETF and ETN. In both cases, ET stands for “exchange traded.” And it’s true: Both are traded on one or more exchanges.

Yet an exchange traded fund is not at all the same as an exchange traded note … any more than an apple is equal to an orange simply because both grow on trees.

Although both are fruit trees, the fruit tastes different.

Today I want to make sure this distinction is clear in your mind. As you’ll see, ETFs and ETNs can leave an entirely different taste in your mouth. You need to know what to expect.

ETN = IOU

Here is the difference in a nutshell …

When you buy an ETF, you receive partial ownership of an independently organized entity — a “fund.” By pooling your money together, you and the other owners do something together that would be hard to accomplish individually.

When you buy an ETN, you’ve loaned your cash to the issuing bank. All you “own” is an unsecured liability. That’s banker talk for an “IOU.”

ETFs and ETNs are similar in certain ways, mainly their ability to create and redeem shares with in-kind or cash transactions. (For more on this process, see my March 2011 column, “Mommy, Where Do ETFs Come From?”) Hence the confusion between them.

In the U.S., ETFs are regulated under the Investment Company Act of 1940. They are chartered as separate corporations. The ETF’s board of directors hires a manager to keep things going. And you, as an investor, own shares of the corporation.

If the manager of an ETF goes bankrupt, what happens to the assets of the ETF? Nothing. There might be a temporary disruption while the board finds a new manager. But the underlying stocks, bonds or other instruments in the fund will be secure. Not so with an ETN.

If your ETN’s issuer fails — even for completely unrelated reasons — the IOU you are holding could be worthless! You’ll be just another creditor when the bankruptcy court divides up whatever is left.

This ETN issuer didn’t survive.

Remember Lehman Brothers? They launched three ETNs in early 2008 under the brand name “Opta.” The tickers were EOH, PPE and RAW. When Lehman failed, ETN investors were left out in the cold. Their money is still tied up in one of the most complicated bankruptcy cases in history.

Knowing Your Borrower
Can Reduce Your Risks

Of course there is nothing wrong with lending money in exchange for an IOU. People do it all the time with great success. I’m sure you will agree, however, that it’s important for the lender (“U”) to at least know the identity of the borrower (“I”).

If you lend your money to a stranger, who then disappears before paying you back, who do you blame? It’s your own fault, frankly. You should have known the risk.

So who is really borrowing the money you “invested” in an ETN? Do you know? Most people don’t … and the ETN industry doesn’t always make it easy to find out.

Here’s a quick test: When you buy the ETN called “ELEMENTS Linked to the SPECTRUM Large Cap U.S. Sector Momentum Index,” ticker symbol EEH, where does your money go?

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Elements? No. Spectrum? No. The stocks in the index? No. The ETN name isn’t just long and unwieldy. It leaves out a critically important piece of information …

When you buy EEH, you’ve loaned your money to Aktiebolaget Svensk Exportkredit. Don’t believe me? Read the EEH prospectus at this link. It’s in the second paragraph after the heading “Issuer.”

These funny-looking words translate into English as “Swedish Export Credit Corporation.” That’s where your money goes when you buy EEH.

If you own EEH, your money is somewhere in this country.

In other words, you’ve loaned your money to a Swedish company. Your return depends on the performance of the SPECTRUM Large Cap U.S. Sector Momentum Index. That’s fair enough, but you also need for the issuer to remain solvent.

The ETN’s name and ticker tell us nothing about Aktiebolaget Svensk Exportkredit. Fortunately the company has a web site in English where you can learn more.

I can’t say much more about this company because I am not an expert in Swedish companies. If I were planning to invest in EEH, I would look into it more thoroughly.

ELEMENTS is not the only firm promoting ETNs, nor is it the only one that leaves the actual issuer’s identity murky. By my count, 196 ETNs are currently available to U.S. investors, marketed under 15 different brand names and issued by 11 different firms.

Most are familiar names like Barclays (BCS), Goldman Sachs (GS), and JPMorgan Chase (JPM). What they all have in common is that ETN investors need them to stay in business.

Notice that the ELEMENTS brand ETNs emanate from four different issuers. You’ll have to do a little research to find out which one is behind any ETN you are considering.

I’m not saying ETNs are never a good investment. I find them useful sometimes, and I’ve recommended a few to my International ETF Trader members. My point is that you should understand — before you buy — who is borrowing your money. Finding out may take a little research, but my table above should give you a giant head start.

Best wishes,

Ron

Ron Rowland is widely regarded as a leading ETF and mutual fund advisor. You may have read about Mr. Rowland and his strategies in publications such as The Wall Street Journal, The New York Times, Investor’s Business Daily, Forbes.com, Barron’s, Hulbert Financial Digest and many more. As a former mutual fund manager from 2000 to 2002, Ron was a pioneer in using ETFs inside of mutual funds. Today, he is the editor of International ETF Trader, dedicated to helping investors use ETFs to profit from ever-changing global market conditions.

What is the return on investment (Interest) on these I.O.U. ( ETNotes) Being Lent To These Borrowers ?

Ron RowlandFriday, November 18, 2011 at 2:09 pm

Steve, unlike regular loans or bonds that have a fixed interest rate, ETNs typically do not pay a monthly interest/dividend check. Instead, their value is linked to the return of an index, and is only payable when the notes mature (typically 20 years after being issued), similar to a zero-coupon bond.

For example, if an ETN were linked to the S&P 500, the borrower/issuer would have to pay the total return (price plus dividends) of the S&P 500 over those 20 years (minus the annual tracking fee) when the note mature. Most investors do not hold them to maturity though, so they are bought and sold based on current value.

The primary exception to this are the MLP based ETNs. Those notes have their priced linked to the underlying price index but they also pay a monthly dividend determined by the yield of the underlying index.

JOSHSunday, November 20, 2011 at 3:29 pm

Hi Ron,
How safe is investing through Scottrade, Etrade and Ameritrade? Scared after the MF Global collapse.